Be Ready for Higher Capital-Gains Tax Rates

When it comes to incurring taxes on your investments, it often pays to procrastinate.

ENLARGE

Guy Parsons

But with long-term capital-gains rates poised to jump at year's end, investors should, at the very least, ready themselves to take action in the months ahead, financial advisers say.

Currently, gains from the sale of assets held more than one year are taxed at a rate of 15% for investors in the 25% income tax bracket or higher, and 0% for investors in the 10% or 15% bracket. Those rates are set to expire on Dec. 31 and revert to 20% and 10%, respectively, unless Congress acts.

What's more, a new 3.8% surtax will take effect in January. Passed in 2010 as part of the health-care act, the tax will apply to investment income for taxpayers with adjusted gross incomes of either $200,000 or more (if single) or $250,000 or more (if married), potentially pushing the top long-term capital-gains rate to 23.8%.

Since the final rates are not yet known, "the best thing you can do now is be prepared to act once Congress has made a decision," says Andy Kapyrin, research director at RegentAtlantic Capital in Morristown, N.J.

Among the questions to consider: Will you need to sell assets soon to raise cash or to diversify a concentrated stock position? How long have you held the assets? And how much are the assets likely to appreciate going forward?

Robert Keebler, an accountant in Green Bay, Wis., outlines some hypothetical scenarios:

John bought stock in XYZ Corp. in February. The shares have since appreciated, but from a tax perspective John shouldn't plan to sell them this year because gains from the sale of assets held for one year or less don't qualify for long-term capital-gains tax treatment, but rather are taxed at higher, ordinary-income tax rates (which also are slated to rise next year).

Bill and Mary have combined taxable income of $50,700, putting them in the 15% income-tax bracket and qualifying them for the 0% capital-gains rate. They expect to buy a house next year and will need to sell assets to raise cash. They should plan to take up to $20,000 of long-term capital gains this year, or just enough to push them to the top of the 15% bracket ($70,700 for married couples).

Mark and Sue are retired but not yet collecting Social Security, the taxable portion of which will bump them into the 25% tax bracket. Like Bill and Mary, they should plan to take long-term gains this year to "fill up" the 15% tax bracket. They could then repurchase the securities they sold, effectively getting a "free" step-up in cost basis by raising the purchase price used to figure capital gains or losses in the future.

For taxpayers subject to the 15% capital-gains rate, the analysis hinges more on how long they intend to hold the assets. If they plan to sell assets soon anyway—say, to raise cash, to diversify a portfolio, or simply because they've lost faith in a particular stock—then realizing capital gains this year could make sense if it means locking in a lower tax rate.

However, the benefit of the lower rate could quickly evaporate for longer-term investors, says Mr. Kapyrin. That's because money lost to Uncle Sam today means less money invested in the market going forward, and less chance to benefit from any future appreciation.

Mr. Kapyrin projected the value of two $500,000 portfolios with equal amounts of unrealized capital gains: a "pay-now" portfolio, where the investor realizes all gains this year at a 15% rate, immediately reducing the portfolio's value by the amount of the tax paid; and a "pay-later" portfolio, where the investor realizes no gains this year, keeping his original $500,000.

Assuming capital appreciation of 6% per year and a future capital-gains rate of 23.8%, Mr. Kapyrin compared the portfolios' after-tax ending balances every year for the next 15 years.

The result: The pay-now portfolio won out in the short term, but the pay-later portfolio resulted in higher ending values for all periods longer than 10 years. With a projected capital-gains rate of 20%, the pay-later portfolio pulled ahead after just six years.

If you do plan to sell assets this year, especially if they're stocks that have run up in the past few years, Mr. Keebler offers one reason to do it sooner rather than later.

"I'm going to tell clients who need the money to harvest those gains right now," he says. Why? Because of the potential for a market selloff later this year.

If tax rates do go up, Mr. Keebler says, "there are going to be a lot of people running for the door."

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